abcInvesting Newsletter, 401k edition

October 2007

In the News: Investment Lessons from the Housing Crisis

401k 101: Contribute or Pay Off the Credit Cards First?

In the News: Investment Lessons from the Housing Crisis

Housing prices are falling in some parts of the country, causing stress for some homeowners. However, other homeowners, even in cities with falling prices, are not in trouble. This brings us to some basic investment lessons from the current housing crisis.

Lesson 1: Don’t buy more house than you can afford because a house is a good investment. We would use the same lesson for stocks and bonds: don’t buy more stocks than you can afford because stocks are a good investment. If you have to take out a high level of debt for your investment, that’s an indication that you are buying more than you can afford.

I have nothing against you buying a house, or taking out a mortgage to buy a house. I have a lot of trouble with someone who can only afford a $200,000 house who stretches to buy a $300,000 house.

Lesson 2: You should be able to live with your investments for the long haul. If you need a “teaser rate” mortgage to buy your house, and you will not be able to make the house payments when the mortgage resets, then you cannot live with that house as an investment. (A teaser rate mortgage has a low initial interest rate, but will reset to a higher interest rate in two or three years.)

We’d say the same thing about someone who invested their 17-year-old daughter’s college savings money in the stock market. Although the stock market has a great track record over long periods of time, it’s not reliable for a short-term investment period.

In the cities with falling home prices, there are families that bought the home they could afford with a fixed rate mortgage. They will be able to make their payments, even thought their home has dropped in value. Eventually, the housing market will turn around and their home will be worth more than they paid for it. At least, that’s what has happened everywhere home prices have ever fallen. If you can wait long enough, you’ll come out OK.

Lesson 3: Be careful of your emotions. Too many people got caught up in the frenzy of speculating on real estate, rather than making cold, calculating decisions. Be cool, be calm.

Dr. Bill Conerly, abcInvesting.com Chief Economist

Contribute to a 401k or Pay Off Credit Cards?

Here’s a quandary that illustrates in the most extreme form the issue of contributing to a 401k or paying off debt. Let’s assume for the sake of argument that this is a fairly high interest rate credit card. Pay off the card first, or contribute to the 401k first?

Let’s describe the happy case where you pay off the credit card first. You put all of your discretionary income to work paying off the credit card tab and avoid adding any more credit card debt. You get out from under the 18 percent (or whatever) interest rate you had been paying on the debt. Now that you are used to living on less money, it’s easy to contribute to your 401k.

Now the unhappy case: you don’t contribute to the 401k, and you still rack up credit card debt. You end up with high debt and no retirement savings, the worst of all worlds.

So what should you do? First, let’s look at how you incurred the debt. Let’s say that your debt was relatively small, but then you had a major unavoidable expense, like a large medical bill, or the car you use to get to work needed a new transmission. You don’t have a behavioral problem, you simply need to dig yourself out of some bad luck. Okay, delay contribution to your 401k—but put yourself on a firm schedule to pay down the credit card debt by a specific date. And keep to that schedule.

Now let’s look at the harder case: you have racked up a large credit card debt simply because you spent too much. Not once or twice, but over and over. Clothes, sporting goods, vacations have all added up over a period of years to a large credit card bill. You really need to change your behavior. If your behavior is not going to change, then fund the 401k so at least you’ll have a retirement account, even though you are wasting thousands of dollars paying a high interest rate.

However, I’d prefer to see you work on the behavior. Here are some steps that frequently help. First, figure out where you are spending money. Use Quicken or another computer program to track expenses.

Second, create a belt-tightening budget. This is a two-step process. The initial step is to create an extremely severe budget, which eliminates all luxuries, frills and recreation. The next step is to add back in a little money for the luxuries and recreation that are most valuable to you. For instance, most married couples should get out of the house without the kids every week or two, so you might add enough for a date—a cheap date, though.

Some people find it hard to avoid using credit cards for impulse buying, but they want to keep a credit card handy for emergencies. Here’s the solution: put the credit card in a zip-lock bag filled with water, then drop the bag in the freezer. You have to thaw the bag to use the card, giving yourself some cool-down time. A simpler version is to keep your emergency credit card in your wallet, but wrapped in paper, taped shut. That may create a bit of bother that prevent impulse buys.

The hard numbers show that paying off a high interest rate debt before contributing to your 401k makes sense, but only if you follow through by paying off the debt and then getting started with your 401k. If you can’t do that, contribute to the 401k and accept that you’ll be in debt for a longer time.

Investment Guide: Investment Vehicles

Only a tiny segment of the market is made up of direct retail investors – investors who manage their own portfolios. Most investors use “investment vehicles,” which pool contributions from many sources and leave the investment decisions to professionals. These include open-end mutual funds, closed-end mutual funds, institutional funds (such as funds for public employee pension plans, charitable trusts, corporate trust etc.), private and collective trust funds, real estate investment trusts and many other fund types. There are many types of investment vehicles, but long-term investments are normally focused on mutual funds.

Mutual Funds

When you buy a share in a mutual fund, you’re buying both a share in an investment company and a service from that company (or more accurately, the management company that sponsors it).

The service you buy is convenient and relatively inexpensive access to the capital markets. The value of your shares in the company depends on the company’s profits (how well the mutual fund invests and performs in the markets).

Structure

When people refer to mutual funds, they usually mean open-end funds that can issue an unlimited number of shares. The more money investors put into the fund, the more shares it issues. There is no limit to the size of a mutual fund: Fidelity’s legendary Magellan Fund has well over $80 billion in assets under management.

Funds use shareholder money to buy assets. The stocks or bonds a fund holds comprise its portfolio, and the financial professional who decides what to buy and sell is the portfolio manager.

Every day the fund’s accountants calculate the value of each share. This is done by totaling up the value of all assets in the fund’s portfolio and dividing that figure by the number of fund shares outstanding. The resulting number is the fund’s net asset value (NAV). All fund managers share one goal – to make the NAV go higher.

Fund managers charge management fees, which are generally pretty small, often less than 1.5% of the money you invest. This small percentage, however, is enough to be profitable for the fund company, since so many people are investing so much money.

Types

There are four general mutual fund types:

Stock funds buy stocks. Their investment objective is usually specific to a certain stock type – small cap, large cap, international, etc.

Bond funds hold only bonds. As with stock funds, they can be designed to purchase particular grades of bonds.

Balanced funds invest in a mix of stocks and bonds.

Money market funds stick with safe, short-term debt instruments such as commercial paper, banker’s acceptances, repurchase agreements and certificates of deposit. Because they have low risk, they typically provide the lowest returns among mutual funds. Their main uses are to park money between investments, hold emergency savings and to save for short-term goals. A small investment in money markets may also reduce some risk in a long-term investment account.

Funds are usually categorized by the type of assets they invest in – small cap stock, intermediate bond, etc. One type of fund that bears a special mention is the Index Fund, which invests in the companies that comprise the various “indexes” (Standard & Poor’s 500, Russell 2000, etc.). The fund buys a portfolio of stocks that are expected to behave almost exactly as the index does. This is called passive management, since the account doesn’t change and the portfolio manager doesn’t make daily investment decisions.

How to Judge Mutual Funds

Because it’s not possible to predict the future, people often look at a mutual fund’s historical performance to gauge how the fund might behave in times to come. While it may be tempting to focus solely on how much money the fund has earned for its investors (the return), it is also important to draw other lessons about the fund, such as the risk level of its investments, its expenses and its style of investing. However, it is important to realize that many things change over time, including market conditions and personnel working for the mutual fund. There are countless examples of funds achieving spectacularly high returns in one year only to incur equally spectacular losses in the following year.

There are many services available to track fund performance, the best known of which is Chicago-based Morningstar Inc.

Morningstar provides data on mutual fund expenses, management objectives, major investments and historical returns. The company also provides the well-known "star" rating for funds -- one to five stars according to performance. In advertisements, fund companies love to tout high Morningstar ratings. But as with any type of numeric or thumbs-up-thumbs-down rating, you should look beyond the rating to learn more about the fund before you invest.

(Excerpted from The ABCs of Your Investments, forthcoming)

Question of the Month: Investment Earning Three Percent per Month?

A reader asks, Hi, I heard about [name deleted] through the radio every week. Their web site does not disclose any details on how exactly their clients get a return 3% or more every month on their money. Their training session costs $2,500 and I am a bit skeptical. Does anyone have any experiences with the aforementioned company as far as being a part of the investing and educational series?

Howard

Thank you for your question, Howard. Let’s put this claim on a basis that we can compare to other investment returns. Three percent per month, compounded monthly, translates to 43 percent per year. That’s exceptionally good. A return that high either comes with a lot of risk, or it’s a scam. We blanked out the name that the questioner asked, so that we don’t have to worry about legal problems, but we’re sure this is a scam.

The top professionals are unable to get this high a return consistently, not even the legendary greats such as Warren Buffett or Peter Lynch.

But suppose that you, yourself, discovered a method that would guarantee such high returns. How would you use that information? Here’s what I would do: I’d put my own money into the investment. I’d talk to family and friends about the investment, offering to use my system with their money, for a share of their profits. I’d put all of my effort into raising money to invest this way.

Here’s what I would not do: Hold public seminars explaining my system. Try to make a business based on radio advertising to sell seminars. That’s what a marketing genius does to make a living, not what an investment genius does. In fact, I’d be very afraid that other people would figure out my idea, because if everyone tries to buy the investment that I want to buy, I’ll have to pay a high price. And if I have to pay a high price, then I’m not going to make 43 percent per year.

Sorry, Howard, but this is pretty certainly a scam.

Elizabeth Harrison, abcInvesting.com Editor

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